The Hidden Cost Of FHA Loans

Certified Mortgage Advisor
NMLS 1701021
Published 
June 2, 2021

Drawbacks that we need to consider

FHA loans are incredible for first time buyers and buyers with credit challenges. You might be looking at the low down payment and the low interest rates with FHA and thinking that this might be the best option for you, but FHA loans have a huge drawback that most people don't consider. So now, I'm gonna share with you the three things you need to consider.

So you can know that you made the right decision when choosing to go an FHA loan. And the last thing that you want is to feel like your new home is a financial prison due to excessive loan costs. So I'll help you learn how to take advantage of an FHA loan rather than it taking advantage of you.

1. Upfront Mortgage Insurance Premium

Number one, the number one thing I want to consider is FHA's Upfront Mortgage Insurance Premium. So all FHA loans require a 1.75% upfront mortgage insurance premium cost.

Why do they do this?

This helps keep the FHA program going. FHA loans are insured by the government which basically means that they need a fund for that insurance. So if somebody defaults on a loan basically FHA is going to come in and help the lender, recoup their losses with it. And that's how the insurance works. They need to pull the insurance. So they charge an upfront fee to people who take out FHA loans. And this is how FHA can offer flexible terms and lower rates than conventional loans can. But for example, let's consider a $300,000 loan, 1.75% means that's $5,250 added to the loan amount.

So month one, your balance with the FHA is 300, $5,250, and with conventional, it's 300,000. So that means that when you go to sell your home, your balance is higher effectively. You have to pay it back that upfront cost because it's financed into a loan. Now, keep in mind that this is because you finance that amount into the loan. Not because you actually have to pay it back to an entity. You're not paying anybody else.

FHA gets their cut upfront. You finance it into the loan amount, but effectively you're paying it back over a 30 year term or a 50 year term, or however long your loan is. And you're paying interest on that premium as well. So if you're getting a 3% rate, you're paying 3% on the 1.75% you added to your loan balance. So we can compare this to a conventional loan with zero upfront mortgage insurance at all and we can see that FHA has a pretty big drawback just without upfront cost alone.

2. Monthly MIP

Now, number two, what I want you to consider we covered the upfront mortgage insurance premium also is FHA's monthly mortgage insurance. FHA has two types of mortgage insurance upfront and monthly. And for most people, FHA's annual mortgage insurance premium is 0.85% of the loan balance, and it stays on there for the entire life of the loan.

Now, this used to be different. It used to fall off before a change in 2013 now all FHA loans follow along these lines. And so that means if your loan is $300,000. The monthly mortgage insurance will be $216 a month and it will be recalculated annually according to the average annual loan balance. Basically every single year it's going to recalculate what that annual premium is. Now, this premium does change based on your loan size and down payment. According to this chart.

So interestingly enough, you can put 10% down on an FHA loan, and your mortgage insurance will drop off after 11 years now, compare with a conventional loan where mortgage insurance falls off anywhere between 20 to 22% equity. This is an incredibly long time to be paying mortgage insurance on an FHA loan, especially considering most of the time FHA the mortgage insurance premium monthly has a higher cost and conventional does right?

Conventional vs. FHA

Conventional mortgage insurance isn't a set number, right? FHA loans, it's always 0.85% based on our loan amount and our down payment which can change and fluctuate with conventional loans. It's gonna be based on the credit score and the risk of the loan as well. And this is going to be a mortgage insurance rate of anywhere between 0.5% to 1% on average.

Can we get rid of FHA mortgage insurance?

The big question is, can you get rid of FHA mortgage insurance? No, not unless you refinance to a conventional loan, there is no way to have an FHA loan to pay it down and then get your mortgage insurance removed without refinancing. Even if you get an FHA loan, and pay it down past 20% equity, you cannot remove the mortgage insurance premium from the loan. You have to refinance to a conventional loan.

MIP and PMI, what's the difference?

It's important to remember too that we hear MIP and PMI, Private Mortgage Insurance is the name given to mortgage insurance for conventional loans. MIP Mortgage Insurance Premium is the name given to mortgage insurance for FHA loans. So those are the differences between PMI is for conventional, and MIP is for FHA.

So how do you refinance, how do you get rid of the mortgage insurance?

This is where you can take advantage of the FHA loan instead of it taking advantage of you.

3. Bridge Strategy

Number three is what I like to call the bridge strategy. We'll cover that in just a second, but why choose an FHA loan? Normally an FHA alone, even though it might have a lower interest rate, tends to have a much higher cost over the entire life of the loan compared to conventional because of the upfront mortgage insurance and because of the monthly mortgage insurance that often doesn't fall off for most borrowers.

And if we take a quick comparison, look at a $300,000 home, FHA is $59,000 more expensive over 30 years than a conventional loan. So when you get an FHA loan, usually it's for a very specific reason, we need to use the FHA loan for a reason. We're not just getting it because it's the cheaper option, because usually, it's a more expensive option.

So likely either some credit issues or that's income issues that are keeping you from qualifying for a usually less costly conventional loan either way you're using an FHA loan, like a tool to help you secure the home that you want so that you can then secure cheaper financing in the future. And I like to call this the bridge strategy. This is the best way to take advantage of FHA loans. It's to get the home that you want now, and then work on what you need to refinance to a conventional loan in the future. So you can save more money, and not pay the extra cost over the entire 30 years that you would with the FHA loan.

Now, there are some, a couple, a couple of considerations to this, obviously, no one knows what rates will look like in the future. But just the high cost of mortgage insurance alone can often offset and increase an interest rate on a conventional loan. A great example of this is I worked with a client with a 587 credit score. So she couldn't qualify conventional cuz he needed a minimum of 620 to qualify conventionally. But at that point, she needed a home just for logistic reasons.

She had to get it out of where she wanted to. It wasn't just something that she wanted to do. So she needed a home. So we helped her get an FHA. And then connected her with a credit coach. So in two years, her credit score was above 680 and she could refinance into a much lower payment on a conventional loan.

So then she can then take that savings and use it to pay off the mortgage faster, use it to pay off debt add it to savings, really anything in there, but that's a much better strategy than holding onto the FHA loan for a long period of time, or to simply just back off from buying at all, because you don't want to get an FHA loan to begin with, right? We use it as a tool.

Being trapped in complacency

The biggest trap I don't want you to fall into is complacency. I see too many people get into an FHA loan because it's what works for them at the moment, and they don't consider the long-term effects of the loan. They just kind of say we got qualified and we don't wanna have to do that again.

So they never look at what they need to work on so they can get cheaper debt in the future. All right. And that's really the name of the game is figuring out how do we refinance it into cheaper debt, along the way. So they sent an FHA loan for years without considering the opportunity cost of what if they did some.

What if they could qualify for conventional in the future? How much could that save them in the long run for some people that might be a small amount for some people that might be a really large amount?

Explore your options

So if you are considering a strategy like this, you can talk to your loan officer and say something along the lines of I think I can only qualify for an FHA loan right now, but would you be able to let me know I need to work on, so in the future I can refinance into a conventional.

There's no such things as bad loan

FHA by no means is a bad loan. However, you have to look at it like a tool, not a long-term option. It's a tool that helps you accomplish something. It's not a product that you wanna hold onto for a long period of time. You can take advantage of it to get what you want and have a plan to save money in the long run. So knowing more about FHA loans really can help you save thousands of dollars. If you go with a correct loan strategy.

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